Can Income Tax Survive Globalization? By Reuven S. Avi-Yonah

Recent headlines about the ability of rich corporations and individuals to avoid paying income tax raise concerns about the viability of taxing income in the age of globalization. Professor Reuven S. Avi-Yonah considers whether income tax has a future.

—

The income tax was created to distribute the burden of financing government according to ability to pay. This means that the tax should be progressive, so that the rich pay more than the poor. But the rich (including corporations, whose shareholders tend to be rich) have the kind of income from business and investment that can easily be shifted from one country to another. In the absence of exchange controls or other barriers to the free flow of funds at the click of a mouse, the income tax is threatened with extinction. If the rich cannot be made to pay, countries might as well abolish the income tax and rely solely on consumption taxes like the VAT, which is much easier to collect since consumption is much less mobile than income. The VAT is regressive (taxes the poor more than the rich), but if the rich cannot be taxed anyway, it is the sensible solution to financing government.

Effective international taxation is thus the key to preserving the income tax in the 21st century. There are two major challenges to the income tax in the age of globalization. The first is tax evasion: Rich individuals hiding their income from investments in offshore tax havens. This is illegal in every developed country, but hard to combat in a world in which small countries boast about their bank secrecy laws. The second is tax avoidance: Large corporations exploiting legal loopholes to shift their business profits to low-tax jurisdictions.

The fundamental problem in both cases is the same: Lack of coordination among the large countries of the world. This suggests that the solution is more co-operation.

In the case of investment income, currently the EU abets tax evasion by rich US residents while the US abets tax evasion by rich EU residents. However, as both the US and the EU have found out, this can also lead to their own residents pretending to be foreigners, and thus evading their own country’s tax. The solution is for the US, the EU and other large countries to impose a refundable withholding tax on all outbound payments of investment income. The tax would be refunded upon proof that the income was declared to the residence jurisdiction of the taxpayer. Since income must be earned in large countries because of investment risk and opportunities, this solution can eliminate tax evasion by the rich without involving the tax havens. Such coordination can deal a real blow to illicit financial flows, which have been estimated to be as high as $15 trillion annually.

In the case of tax avoidance on business income, most multinationals have their headquarters in the G20 countries, and no G20 member has a corporate tax rate below 20 percent. Thus, if all the G20 could commit to not reducing their rates below 20 percent, they could all tax their multinationals on a worldwide basis without affecting competitiveness (especially if they also adopted a more demanding definition of corporate residence and corporate exit taxes). This in turn would allow the countries in which multinationals earn their business profits, both developed and especially developing, to reassert their right to tax such income at source. The corporate tax is much more important to developing countries than to developed ones, so this measure of coordination can be really significant in achieving a more just distribution of global resources.

Following the 2008 financial crisis, governments have been much more interested in such cooperation, since their citizens have vehemently objected to paying more tax while the rich and large corporations escape their fair share. Following the enactment of the US Foreign Account Tax Compliance Act of 2010 (FATCA), which was designed to force foreign banks to reveal information about accounts controlled by US residents, over 80 countries have pledged to cooperate in automatic exchange of information. At the same time, the G20 have prompted the OECD to launch the Base Erosion and Profit Shifting (BEPS) project, which is a promising beginning to more coordination in taxing large multinationals.

These steps toward coordination are good but not sufficient. Automatic exchange of information can be stymied by one non-cooperating tax haven through which all the money can be funneled. BEPS does not fundamentally attack the ability of multinationals to shift funds to low tax countries; it just makes it more complicated (and thereby enhances the value of tax advisors).

If income taxation is to survive, more political will must be found. Unilateral steps like FATCA and the new UK diverted profits tax are helpful but limited in scope (both can be avoided by not doing business in the US and the UK, respectively). The only solution is true cooperation among the G20. It’s a tall order, but much easier to imagine than (for example) Thomas Piketty’s global wealth tax, which requires every single country in the word to sign on.

If the G20 are serious about saving the income tax from tax evasion and avoidance, now is the time to act together.

Reuven S. Avi-Yonah is the Irwin I. Cohn Professor of Law and director of the International Tax LLM Program. He specializes in corporate and international taxation and has served as a consultant to the U.S. Department of the Treasury and the Organisation for Economic Co-operation and Development (OECD) on tax competition. He is a member of the steering group for OECD’s International Network for Tax Research and is also a trustee of the American Tax Policy Institute, a member of the American Law Institute, a fellow of the American Bar Foundation and the American College of Tax Counsel, and an international research fellow at Oxford University’s Centre for Business Taxation. His latest book Advanced Introduction to International Tax Law is soon to be published by Edward Elgar.